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Tuesday, May 31, 2011

I recently saw an episode of Law & Order: LA called “Angels Knoll” whose villain was intended to be like Bernie Madoff, the swindler who took investors for billions in an enormous Ponzi scheme. Now I’m not naive enough to think that it’s the role of television shows to educate the masses, but I was disappointed that the show perpetuated a widely-held misconception about Ponzi schemes.

Parts of the show involved prosecutors searching for the billions the Madoff-like character stole from investors. However, in real life, most of the “stolen” money in Ponzi schemes never existed. When a Ponzi scheme blows up and the perpetrator is found out, investors hold statements saying they have large accounts, but the money doesn’t exist.

In fact, in most cases the hapless investors have been receiving phony statements for years. With each passing year, the gap between the statement figures and the real money keeps getting larger. By the time the scheme collapses, there is usually very little real money to back up the phony statements.

Not only does the total amount owed to investors not exist, but most of it never existed. To keep the scheme going, most Ponzi operators show fictitious high returns on each statement sent to investors. The total amount of money that flowed through the scheme may be only a small fraction of the amount that investors thought they had just before the scheme collapsed.

So, searching for the billions made little sense in the television show, but I liked the episode anyway.

Monday, May 30, 2011

Most of us dream of a comfortable retirement with the freedom to do what we want. We'd also like this retirement to start when we're young enough to enjoy this freedom. Parts of the investing industry tap into this desire with a self-sustaining marketing strategy.

We regularly see ads with images of retirees traveling, golfing, and generally enjoying an upper-middle class retirement lifestyle. While it is possible for an individual to achieve such a retirement, we can't all achieve it; there just wouldn't be enough young people to maintain golf courses, prepare food for us in restaurants, and provide all the other services desired by an army of wealthy retirees.

This guarantees that most people will fall short of the retirement dreams that are marketed to us. Most people are also aware that they are not on the right financial track for a dream retirement. This leads to the next type of marketing: retirement polls.

There is no shortage of retirement polls that reveal that most of us are worried we haven't saved enough. And based on the lofty goals of dream retirements, it is true that most of us haven't saved enough. This is regularly revealed by studies of how much money people should have saved by certain ages and how far short of these goals most of us have fallen.

The perfect thing about this marketing approach is that it never has to change. As long as the retirement dream remains beyond the reach of the average person, most people will necessarily fall short. And some fraction of these people will seek help from expensive investment helpers.

Friday, May 27, 2011

Canadian Capitalist says that he has a foolproof method of saving big on conversions between Canadian and U.S. dollars.

Wealthy Boomer reports on an Investors Group study showing that most people aren't overly concerned about debt. I find this one funny because it was an Investors Group representative who pushed hard to get me to borrow a large sum to invest in stocks just before the tech meltdown a decade ago. It's a good thing for me that I declined.

Million Dollar Journey addresses the question of why most of us aren't rich. I'm not sold that debt for leverage is necessary, but guest writer Ed Rempel makes a number of other strong points.

Preet Banerjee runs the numbers on a pitch by a door-to-door hot water heater salesperson with questionable sales techniques.

Thursday, May 26, 2011

Recently I was pleasantly surprised to receive a gift certificate redeemable at Amazon. However, my happiness was short-lived.

The first clue to potential trouble was that the amount of the gift certificate was £620. It’s not too uncommon for me to get U.S. dollars, but I don’t often receive British pounds. A scan of the gift certificate’s fine print revealed the following:

Wednesday, May 25, 2011

I’m often struck by the extreme difference between the cost of my business travel and the cost of my personal traveling choices. But it’s not just the cost that is different, but my attitudes about what types of accommodations, flights, and meals are acceptable differs depending on whether my travel is personal or business. It’s as though I have a split personality.

As examples of costs, the airfare of my last two business trips adds up to about $11,700, but the total cost of my last vacation (of 8 days) was $1200 including food, golf, accommodations, and airfare.

As an example of attitudes, I’m content to sleep on a bunk-bed and eat burnt toast when I’m on a personal golf trip, but I find myself critical of small things at hotels when on business travel such as inefficient handling of my luggage or poor timing of maid service.

I’d be interested in knowing how common it is for people to have very different spending personalities in different contexts.

Tuesday, May 24, 2011

The book Investing and the Irrational Mind by behavioural finance expert Robert Koppel brings together a comprehensive collection of ways that our minds steer us to irrational decisions. The focus is on the behaviours of traders, but any type of investor can benefit from reading this book.

While reading this book it would have been easy to read each irrational tendency and feel superior because I don’t do such dumb things. However, pausing to think about each type of mistake I had to admit that I was guilty of most of them at one point or another in my investing life. I think the reader is likely to get more benefit from this book by trying to think of examples of his or her own mistakes.

I definitely recommend this book to anyone who is serious about becoming a more rational investor. Those who hope to make their living trading may get even more benefit. In my case, my attempts at rational analysis have led me to give up on trading and focus on long-term index investing.

Here are a few interesting quotes:

“We fluctuate irrationally between an aversion to losing and our own delusional optimism.”

“Never attempt to buy at a bottom or sell at a top of a market: this is a feat achieved only by liars.”

Attributed to MIT’s Sloan School of Management professor Andrew Lo: “Much of what behavioralists cite as counterexamples to economic rationality – loss aversion, overconfidence, overreaction, mental accounting, and other behavioral biases – are, in fact, consistent with an evolutionary model of individuals adapting to a changing environment via simple heuristics.”

“Our brains view the market as an issue of life-or-death survival rather than one of arithmetic problem solving.”

“Investing, contrary to popular belief, is not a good recreational activity.”

“Virtually all of the [arthritis] patients interviewed were certain that their bouts with the illness were correlated with the weather. In fact, the actual correlation was close to zero.”

Friday, May 20, 2011

The Economist takes a thoughtful look at which occupations require licensing and what the advantages and disadvantages of requiring people to have licenses before practicing these occupations. The main purpose of licensing is to control the number of practitioners and inflate their pay. But requiring licensing is usually justified as a means to guarantee a minimum standard. (Hat tip to the Stingy Investor for finding this article.)

Preet Banerjee brings more analysis of whether Warren Buffett’s track record is luck or skill. A part of this analysis is more bashing of the normal curve. An important this to understand about the normal curve is that it is an approximation to reality that usually works well for predicting things about likely events and is way off for predicting extreme events. The real skill of a statistician is understanding when the normal curve applies and when it doesn’t.

The Blunt Bean Counter gives us the benefit of his extensive experience with explanations of six typical situations when you would have to deal with CRA and how serious they are.

Larry MacDonald (this web page has disappeared) explains some things people should know about annuities. I’d like to know more about contractual risks. Under what circumstances and for which types of annuities can an insurance company reduce payouts?

Thursday, May 19, 2011

The more I learn about investing the more I realize that the smartest investment choices for me are the boring choices.

Trading frequently is much more exciting than hardly ever trading, but I’m better off trading only a few times per year. I used to invest in individual stocks, but the more boring index investing is better for me.

I’ve looked at various forms of market timing, but I always end up concluding that buy and hold works better for me. I’ve studied currency hedging on foreign investments, but it seems that I’m better off without hedging.

Trailing stop orders to try to minimize losses look interesting, but I’ve concluded I’m better off without them. Investing in asset classes that are outside the usual choices such as commodities would add some excitement, but I think I’m better off without them.

I won’t say that I think everyone should make the same choices I’ve made, but boring works for me. I’ll find excitement in something other than investing.

Wednesday, May 18, 2011

We frequently here the stock-picking advice “cut your losers and let your winners run” (for example, see this SmartMoney article). This advice sounds smart. After all, isn’t better to own winner stocks that loser stocks? The problem here is that we only know a stock’s past and not its future.

A personal counterexample was my purchase of Apple shares in 2000 and later sale in 2003. I had lost 14% of my investment over those 3 years; so it seems that I followed the rule because I sold a loser. However, Apple stock went on to grow at an average compound rate of about 45% per year since then. My shares would be worth more than a million dollars had I held on.

Of course, one example doesn’t disprove a useful investing rule. And some may argue that I actually sold a winner that had a temporary setback. However, this is something that I didn’t know at the time I made my decision to sell. We’d like to think that we could have known that Apple had big things ahead, but this is just hindsight bias.

I’d be interested in seeing a study of whether cutting losers and keeping winners actually works in the sense that it beats the market. The study would have to precisely define which stocks are winners and which are losers based on past data and not future data. Without a convincing study of this type, I remain sceptical that this advice is anything more than a way to exploit our hindsight bias to make us feel bad about stocks that didn’t work out.

Tuesday, May 17, 2011

“My client is interested in either a p-.90% rate or the p-.50% CIBC 3% cashback mortgage. I’ve used your spreadsheet and (if I used it correctly) it says the equivalent of the cashback product is basically p-1.18%.

How would I calculate what the equivalent rate is if the client immediately invests the cashback into the mortgage as a prepayment?”

First, a little background. With cash-back mortgages the bank gives you some extra cash (3% of the mortgage amount in this case) when you sign up for the mortgage. They also charge a higher interest rate to make your payments higher so that they get their money back during the term of your mortgage. I created a spreadsheet to figure out the effective interest rate you’re paying with one of these mortgages.

After using the spreadsheet, it seems that the reader’s numbers are consistent with a 5-year term. If this is right then I think he used the spreadsheet correctly.

If the client makes prepayments on the mortgage, the equivalent rate gets even lower. How much lower depends on the amount of prepayment. We can see this by looking at an extreme case. Suppose that the client takes out the mortgage, accepts the cash-back, and then immediately pays off the entire mortgage. In this case, the client gets to pocket the entire cash-back amount.

Obviously the bank would not permit this. I’m suspicious that the bank may even not permit the modest 3% prepayment. If the reader can determine what prepayments are permitted by the bank on this type of mortgage, I can make a version of the spreadsheet that computes the effective rate for prepayment cases.

Monday, May 16, 2011

It is reasonable for prospective students to pay some fee to apply to a university program. However, these fees seem to be rising fast. This makes me wonder if university applications are seen as a profit center rather than just something whose cost must be covered.

A student I know recently paid $192.50 to apply to three programs at one university in Ontario. I’d be interested in seeing a justification of this price. It seems high enough that someone is making a profit.

Many applications can be handled quickly because the student either definitely qualifies or definitely doesn’t qualify. Borderline cases are more costly to handle, but it seems unlikely that the average cost could justify the price of $192.50.

I’d be interested to hear expert opinions on costs from readers who have knowledge of the application process.

Countries differ in the number of index funds available, and they differ in the degree to which actively-managed funds pretend to manage actively, but actually stay close to an index (closet indexers). Here are some of the findings:

1. The more explicit indexing available in a country, the lower fund fees tend to be.

2. The more closet indexing in a country, the higher fund fees tend to be.

3. The more closet indexing in a country, the worse fund performance tends to be.

4. The most actively-managed funds (furthest from closet indexing) tend to charge higher fees, but also tend to have higher returns.

To oversimplify, this paper says that explicit indexing is good, closet indexing is bad, and true active management is better than closet indexing.

Wednesday, May 11, 2011

Most Canadians and Americans will say that they are believers in capitalism. But when push comes to shove, we’re often very annoyed by the consequences of capitalism.

A good example I experienced recently came when stiff winds uprooted trees, lifted roof shingles, and destroyed fences in my area. In the aftermath there was a run on fence posts and bags of cement. All the local suppliers ran out for about a week.

If the suppliers had raised prices during peak demand consumers would have screamed that they were being gouged. A part of capitalism is the idea that prices rise and fall with changes to supply and demand. If suppliers had raised prices high enough, only those who really wanted their fences fixed right away would have bought materials and there would not have been any shortage.

By being spared the consequences of capitalism in this case we had to put up with shortages. Rather than having the materials go to those willing to pay the most, they went to those who arrived at the store first.

Tuesday, May 10, 2011

I had a family member tell me recently that her feeling of wealth has almost nothing to do with the size of her portfolio. Long term savings are just numbers on a computer screen. Whether she feels rich or poor is driven by just a couple of things:

1. Debts
2. Cash in a regular bank account

This means that transferring money from her bank account to her RRSP makes her feel less wealthy. In a sense, the money is gone even though it is now poised to grow over time. On one hand, this all seems very irrational, but on the other hand I’m impressed that she understands herself quite well.

One consequence of her formula for feeling wealthy is that leverage is a problem. With leverage she’d have a large debt with no offsetting pile of cash in a bank account.

Have you figured out the drivers for your feelings of being rich or poor?

Monday, May 9, 2011

The concept of the rational investor has come under attack in recent years with the rise of neuroeconomics. It seems that we bring many biases, illusions, and other irrational thinking with us when we make investment choices. What does this make of my oft-stated belief that investors should strive to control their emotions and make rational decisions?

I’ve been told that because we now have strong evidence that investors are driven by so many emotions, my support for rational investing is passé. I don’t dispute the lessons of neuroeconomics; investors have many biases and often make emotional investing decisions.

However, just because we do make emotional choices doesn’t mean that we are best off investing this way. Even if we need to understand the emotions of others to best understand equity markets, we still do better as investors to push emotions aside and make rational choices that take into account the irrationality of others.

Studying neuroeconomics is fascinating. It gives great insight into why markets behave as they do. It also shows us what mistakes we should try to avoid. Investing rationally is the best approach.

Friday, May 6, 2011

The Annual meeting at Berkshire promised to be more interesting than usual due to David Zokol resigning amid accusations of trading in Lubrizol shares before recommending that Berkshire buy the company. Michael J. de la Merced produced a minute-by-minute account of the meeting.

Canada Mortgage News reports that TD bank is unable to accept collateral mortgage transfers. This makes it clear that TD’s change to registering mortgages as collateral mortgages will make it very difficult for clients to transfer (or threaten to transfer) to another bank.

Jason Zweig explains how funds holding Treasury inflation-protected securities, or TIPS, can report returns that are higher than the TIPS actually pay.

Rob Carrick invites you to have your say on which are the top money blogs.

Thursday, May 5, 2011

“Stick to your investment plan but be prepared to make adjustments.” Advice like this is usually presented as a nuanced version of the familiar advice to stick to your investment plan. I see it as simply self-contradictory.

Advising people to be prepared to adjust an investment plan is not difficult to sell. Sticking blindly to a plan is good advice for most investors, but a sophisticated person like you can do better by being prepared to make subtle course corrections when necessary. I hope your BS meter registered something with that last sentence.

By “sticking to an investment plan” we usually mean adhering to particular asset allocation percentages and saving some percentage of income regularly. “Making adjustments” usually means changing your asset allocation percentages. You can’t make changes and stick to your plan all at once. It’s one or the other.

Sometimes changing your investment plan really does make sense if the underlying assumptions of the plan are no longer true. For example, if one of your funds changes its focus from an index of large-cap stocks to trading in jumping bean futures it definitely makes sense to find another fund. Another good time to make a change is when you wake up to the fact that you’re paying 3% of your assets each year in fees.

However, if you decide to make adjustments to your plan because of market conditions and your conviction that some asset class is destined to move in a particular direction, you are not just adjusting your investment plan – you are changing it, at least temporarily.

Just like any active investor, if you tinker with your plan regularly, you should keep track of how these hunches work out. Write down the change and sometime in the future work out whether the change caused you to make or lose money compared to the strategy of sticking with the original plan.

If you’re like most investors, a lifetime of tinkering will add up to losing money compared to sticking with a plan. However, if you don’t actually check, it’s easy to hallucinate that your guesses have worked well. I’d rather have more money than have a false good feeling about my financial clairvoyance skills.

Wednesday, May 4, 2011

Update: Turner resolved the apparent contradiction by explaining that while some advisors associated with the firm that provides back office services for his practice do accept commissions, Turner does not accept commissions.

The discussion of Garth Turner’s blog over at Canadian Capitalist prompted me to take a look at Turner’s investment advisory business where I found an apparent contradiction about commissions that I can’t resolve. (The web page for Turner's advisory business (at the time of this writing) has disappeared.)

The “Home” tab of the advisory business site says “we do not collect, seek or accept commissions” and “Our clients pay only a small fee (typically 1% annually of the assets we administer for them)”. This seems clear enough: no commissions.

Under the “Investment Choices” tab we find a list of investments that include some “instruments - through commission or fee-based programs”. So do you collect commissions or not? Exactly what fees do your clients pay? There seems to be some complication with two separate companies. Perhaps Turner’s company doesn’t collect commissions, but the second company does.

It’s hard to tell but perhaps Turner’s company just adds a 1% fee wrapper on top of the typical high Canadian fees charged by the second company. In the end what matters is the total amount of fees paid by investors and the quality of the advice they get for their money. I can’t figure out either side of this equation from Turner’s web site.

Tuesday, May 3, 2011

With Stephen Harper’s Conservative party winning a majority in yesterday’s election, we can expect some significant tax changes for individuals, but not any time soon. Combing through the Conservative platform, I found only one measure aimed at individuals, the extension of the ecoENERGY program, that is likely to benefit me in the short term. All other interesting measures only kick in once the federal budget is balanced, if that ever happens.

The three promises that would affect me most are

– Family tax cut: The ability to shift up to $50,000 of income from one spouse to another each year.

– Doubling TFSA limit: New yearly contribution limit of $10,000.

– Adult Fitness Tax Credit: Do we get credit for the cost of the post-game beer?

I suppose it makes sense to make expensive promises contingent on healthy country finances, but such goodies also play well politically when your opponents are making big spending promises. Here’s hoping that we actually get the budget balanced within a decade, even if the Conservatives aren’t around to enact their promises.

Monday, May 2, 2011

Any time a U.S. stock takes a big drop there is a good chance that some law firm will launch a shareholder lawsuit. From my days of picking individual stocks I’ve received my fair share of requests to join class-action suits and my share of invitations to share in the spoils of a successful suit. I’ve never bothered until recently.

I had the misfortune to have bought Tyco stock about a decade ago and lost quite a bit of money. A lawsuit alleged that Tyco “violated the federal securities laws by, among other things, fraudulently overstating its financial results, improperly using excess reserves to enhance and smooth those reported earnings, and failing to disclose to investors substantial amounts of senior executive compensation and a large number of related party transactions.”

Tyco admits nothing, but they did agree to pay $50 million to shareholders and I’m entitled to my slice. On the off chance that I’ll actually get a non-trivial settlement, I decided to fill out the paperwork to get my share. I had to supply sufficient proof of my trades and fortunately I’ve kept copies of every stock transaction I’ve ever made.

It will be interesting to see if I actually get any money. Being a Canadian and not having a Social Security Number could be a show-stopper. I’m sure there are other possible reasons why I won’t get paid that I can’t anticipate right now. But I wouldn’t have gone to the trouble if I thought there was no chance. Wish me luck.